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Tuesday, July 5, 2011

Universal Power Group: Cheap

Universal Power Group (UPG) is a distributor of batteries and related accessories. This is a boring business with low, though positive, returns on assets. Nevertheless, value investors may be excited at the fact that they can buy these assets, most of which are liquid, at a large discount to book value.

UPG has net current assets of $43 million against total liabilities of just $22 million. But the company trades for just $15 million on the Amex. Meanwhile, the company is profitable, having generated almost $3 million in profits in 2010. Through the first three months of 2011, however, profits are down as a major customer has sharply reduced purchases. Nevertheless, UPG managed to cut expenses and grow sales to other customers enough such that the company remains profitable.

There are some items for concern for potential shareholders, however. The latest financials do not include an acquisition that took place following the reported March end-date. In April, UPG acquired a company for more than $3 million. UPG already had $11 million in debt against almost no cash, so this acquisition increases the investment's risk as it adds to the company's debt burden. More important than this single acquisition, however, is the possibility that the company will spend all of its cash flow in an attempt to grow, with no regard to shareholder value.

Management does own a large stake in the business, however, which should serve to somewhat mitigate the desire to empire-build recklessly. But there are some worrying signs for investors. For one thing, the company has never bought back shares nor paid a dividend, even though shares became very cheap in early 2009.

Furthermore, the company recently passed a resolution to allow the Board to re-price options that have been paid out to executives and that are now underwater as the company's stock price has fallen. This is a sign that management wants all the rewards that come with good fortune, without any of the risk. As the company explains:

"When exercise prices of outstanding options...have exercise prices that are significantly higher than the fair market value of our common stock, our Board believes it unlikely that these options will be exercised in the near future and as a result will not provide the incentives to our employees that the options were intended to provide."

This is hardly an adequate justification for why these exercise prices should be re-priced. Had the share price exceeded the "intended to provide" incentive instead, would these exercise prices have been re-priced upward? Likely not.

But this shareholder-unfriendly measure passed anyway, in large part because management has effective control of the company. As the current CEO is just 38 years old, he likely attained his position with a little hard work and a whole lot of nepotism; his father-in-law is Chairman of the Board, with beneficial ownership of 45% of the company.

Assets on the cheap are always nice to have. But for shareholders to benefit, those assets have to be deployed in a shareholder-friendly way at some point. When a company is effectively controlled by a group that has a history of being unfriendly to shareholders, however, such a scenario appears unlikely.